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Dozen things about investing from Richard Thaler

Recently an article published on Bloomberg, Richard Thaler is not only a famous economist and author, but is also part of a very successful fund, the 70-year-old University of Chicago professor, whose stock-picking theories drive the Undiscovered Managers Behavioral Value Fund, is getting discovered in more ways than one:

“Behavioral economics [is] a field that only exists because regular economics is based on an idealized economic agent, sometimes called Homo Economicus. In the book we refer to such creatures as Econs. Econs are creatures that can calculate like a super computer, never get tempted by fatty or sweet foods, never get distracted, and probably aren’t a whole lot of fun to be around. In contrast, real people, who in the book we call humans, don’t make any appearance in standard economics. Behavioral economics is economics about humans. Humans are busy, can’t solve every problem instantaneously, and get tempted by luscious desserts. Sometimes they need some help.”

“Models of Econs may provide good approximations of what happens in the real world…. but those situations are the exception rather than the rule.

The combination of free entry, unfettered competition, and free choice seems hard to quarrel with.… However, if participants are not well-informed or highly motivated, then maximizing choice may not lead to the best possible outcome.” “If people starting new businesses on average believe that their chance of succeeding is 75% then that should be a good estimate of the actual number that do succeed. Econs are not overconfident.” “Economists assume people are unboundedly unscrupulous—or I’ll say self-interested, a more polite term. But there have been lots of experiments where you leave a wallet out and depending on the place—I don’t remember the exact data—but a large percentage get returned.” “There’s no reason to think that markets always drive people to what’s good for them.” “Most economists recognize that some of the people are not fully rational some of the time, and some of the time that matters.”

“Most of economic theory is not derived from empirical observation. Instead it is deduced from axioms of rational choice, whether or not those axioms bear any relation to what we observe in our lives every day. A theory of the behavior of Econs cannot be empirically based, because Econs do not exist.”

“You can [beat the market] but it is difficult.” Warren Buffett once said: “I’d be a bum on the street with a tin cup if the markets were always efficient.” His partner Charlie Munger adds: “There’s no way to make investing easy

In some ways the, the venerable Ben Graham has been given a Fama-French seal of approval, since they also endorse value and profitability.

Rational models are one hundred percent flexible. If you allow time-varying discount rates, there is no discipline whatsoever. If you look at what happened to tech stocks and then to real estate, and you say maybe there wasn’t a bubble—where is the discipline in that?”

Diversification Bias: “When an employee is offered n funds to choose from in her retirement plan, she divides the money evenly among the funds offered. Use of this heuristic, or others only slightly more sophisticated, implies that the asset allocation an investor chooses will depend strongly on the array of funds offered in the retirement plan. Thus, in a plan that offered one stock fund and one bond fund, the average allocation would be 50% stocks, but if another stock fund were added, the allocation to stocks would jump to two-thirds.”

Loss Aversion: “When they have to give something up, they are hurt more than they are pleased if they acquire the very same thing.”

The House Money Effect: “The money that has recently been won is called ‘house money’ because in gambling parlance the casino is referred to as the house. Betting some of the money that you have just won is referred to as ‘gambling with the house’s money,’ as if it were, somehow, different from some other kind of money. Experimental evidence reveals that people are more willing to gamble with money that they consider house money.”

Status Quo Bias: “Hundreds of studies confirm that human forecasts are flawed and biased. Human decision-making is not so great either. Again to take just one example, consider what is called the ‘status quo bias,’ a fancy name for inertia. For a host of reasons, which we shall explore, people have a strong tendency to go along with the status quo or default option.”

Optimism Bias: “The ‘above average’ effect is pervasive. Ninety percent of all drivers think they are above average behind the wheel.” “People are unrealistically optimistic even when the stakes are high.” “I think the people who’ve been the most overconfident in our business in the last decade have been the people who called themselves risk managers. And the reason is they failed to learned the primary lesson we should have learned from when Long Term Capital Management went belly up ten years ago. That is, investments that seem uncorrelated can be correlated simply because we’re interested in it. …the world is much more correlated than we give credit to. And so we see more of what Nassim Taleb calls ‘black swan events’– rare events happen more often than they should because the world is more correlated. I think one lesson we have to learn is that there’s a lot more risk than we’re giving credit to, a lot more what economist calls systematic risk. I think we also have learned the lesson that we have to have better incentive structures.”